Reputation is crucial for bank investors

John Coffee at podium

The humbling of two global banks in recent weeks has been greeted very differently on opposite sides of the Atlantic. Still, from the perspective of either side, large fines for interest rate rigging by Swiss bank UBS, and money-laundering by HSBC, point to the same conclusion: from now on, banks must protect their reputations as their most valuable asset.

On the US side, there has been considerable grumbling about the “lenient” treatment meted out to HSBC and UBS. Associations with Mexican drug cartels and Iranian militants or documented solicitation of price fixing usually attract the attention of federal prosecutors. Yet, while UBS’s Japanese subsidiary did plead guilty to one criminal count and two of its employees face charges, not a single HSBC employee faces any form of criminal or civil sanction. Nor has the parent entity been charged in either case. Given similar recent problems at Barclays and Standard Chartered the question from the US perspective becomes:

Why are British and European banks not more law compliant? From the British side concern is growing about the “punitive” nature of American enforcement. Why is the US “obsessed” with criminal prosecutions? In the US the idea that “too big to fail” means “too big to prosecute” has become politically unacceptable. But in the UK there remains a fear that criminal prosecutions could lead to a major bank failure, potentially destabilising international banking and chilling economic recovery.

These rival perspectives dovetail with longstanding differences in approaches to enforcement. The US remains committed to a deterrent orientation for law enforcement. From this perspective, one best prevents misbehaviour through aggressive enforcement and the prospect of penalties that exceed the expected gain from wrongdoing.

In the UK, financial regulators have long believed in quiet admonitions and private censure.

Although few still talk openly about “light touch” regulation in the UK, the philosophy remains that one should minimise regulatory intrusions into the marketplace. From this perspective, the appropriate goal of policy is to change the culture of a delinquent institution so that it becomes more compliant with the law. This implies that one should use the least drastic means necessary.

Although the “light touch” did not work with HSBC, which persisted in wrongdoing, its final settlement with US and UK regulators incorporated this gentler, rehabilitative approach. HSBC’s senior management is now populated with compliance officials from regulators in an attempt to change the institutional culture. It is as if financial regulators decided to colonise the “rogue” institution, compelling it to import persons of a “proper” compliance temperament. A straw in this same wind is Barclays’ decision to hire Hector Sants, the former head of the Financial Services Authority, as its new compliance chief.

What do these differences in enforcement styles between the US and the UK imply for global banking? In all likelihood, these differences will persist. UBS’s market price barely moved after its Japanese subsidiary was charged, undercutting the claim that prosecuting a bank implies its failure. That may encourage US regulators to be more aggressive.

Global banks must anticipate more aggressive enforcement, as they cannot escape the US market. This means that investment in a robust compliance system is essential. But robust compliance begins with “the tone at the top”. Chief executives of global banks will need to recognise that, like Caesar’s wife, they have to be above suspicion. Part of UBS’s continuing problem is that its co-CEOs cannot seem to escape some supervisory responsibility for its role in manipulating interbank lending rates. Only if senior management is clearly on the “side of the angels” is there much chance that a major bank can avoid future punitive treatment in the US if its underlings cross the line.

Reputation always counted. But in future it will mean much more than personal honesty and candour (which were always valued). It will also mean a zealous, no-nonsense approach to compliance with near-zero tolerance for misconduct.

This will become clearer as events unfold. Regulatory penalties in the Libor scandal are only the first step. Private enforcement through class actions and other lawsuits in the US may raise the costs of that scandal by an order of magnitude. The investment banks serving Enron eventually paid more than $7.5bn to settle the class action against them.

In such an environment, financial institutions need to signal credibly to the market that they are law compliant. No rational manager tolerates misconduct when the expected costs exceed the expected benefits. But avoiding cost-inefficient misconduct alone is not enough. The signal must be clear: involvement in misconduct must be career-ending, even for those who only failed to supervise adequately. For large financial institutions who have evaded the sunlight of disclosure (often with regulatory acquiescence), the transition will be difficult.

In the UK, the same bottom line follows: as the public has become suspicious of large banks, Reputation becomes critical, both as the glue that holds together organisational culture and as the deciding factor in enforcement negotiations.

As the value of reputation grows, much may change. The path to the top of banks may shift.  Regulatory experience may be valued more highly, rather than indicating that an executive is only suited to second-tier responsibilities in compliance.

Above all, global banks will need to compete not only over the price and quality of their services, but over reputation. And in the competition to reach the top, the future global bank chief executive will increasingly be the person who can best enhance that reputation.

A version of this column originally appeared as an op-ed in the Financial Times and is available here.